Tuesday, April 22, 2008

Filed under ZALES :- Today I would like to call attention to specialty retail jeweler, ZALE Corp, (NYSE:ZLC) and the difficult challenges it must overcome to successfully outperform the market. After a brief analysis, I have come to the conclusion that it will face many uphill challenges in the coming year. A weakening economy coupled with an inflationary environment will hamper efforts to revitalize the retail jewelry market, especially where specialty brick and mortar retailers already face stiff competition from all fronts including: booming Internet sales from as Blue Nile (NASDAQ: NILE) and Ebay (NASDAQ: EBAY), discount retailers such as Wal-Mart (NYSE:WMT), and high end retailers such as Tiffany's (NYSE: TIF).

Investors looking into Zales must keep in mind that the majority of its sales and profitability comes from the holiday season centered around Christmas. The remaining quarters are loss leaders, and produce no positive earnings per share. It will be difficult to access Zales true performance until the early 2009, when the results of the future holiday season are to be posted. Investors need to be prepared for the fact that for the next three quarters, a negative earnings per share of -.54 to -.62 is to be expected, according to a Standard and Poor report based upon forcasted operating EPS. That is a long 9 month wait for any positive news to come from Zales, where alternatively, capital could be allocated to more effective uses.

Along with the recession, and weakening consumer demand I'd like to address several issues that Zales faces in the next three quarters.

MANAGEMENT

The question of Zales' success hinges on whether management has the ability to turn around an already fledgling retailer and stimulate consumer appetite amid a difficult retail environment. On the heels of Zales management is Richard Breeden, a former SEC chairman turned shareholder activist who recently acquired a 13.5% stake in Zales. There is immense pressure for Zales management to improve results, or face the prospect of a buyout. With the appointment of Neal Goldberg, former CEO of specialty apparel retailer, Children's Place NYSE: PLCE, it is difficult to say so. His new appointment at Zales retests many of the same challenges which he oversaw at the Children's Place, including a weakened demand for premium retail products, and pressure from activist shareholders such as Carl Icahn, like Breeden who have short timeframes for turnarounds. Under his previous management position as President of The Children's Place, NYSE: PLCE, he oversaw the unsuccessful merger with Disney Stores, which floundered for several years, resulting in its eventual divestiture, along with attracting a lawsuit accompanying the Children's Place and its breach of contract for non-performance. Could a disastrous turnaround plan, again, under pressure from activist shareholders tempt Zales management to pursue an opportunity of opposite synergies? A Catch-22 situation can only serve as a distraction to management as they seek to realign their core competencies towards the middle jewelry market.

EARNINGS

Zales, being a specialty retailer, recognizes the majority of its revenue during its quarter ended Jan 31th. Earnings from continuing operations totaled just 59.2 million dollars for 2007,or an EPS of 1.21 for fiscal year 2007. Investors should note that the to a sale of bloated inventory accounted for 13% of the net income applicable to common shares for 2007. In the future, I expect that Quarter 2 results, which should be released sometime around May 31st, will undoubtedly have charges due to discontinued operations, and the planned closure of 105 stores. Severance costs which will immediately be charged to income could possibly hamper second quarter earnings, as well as a $100 million share buyback program announced on March 27th. Any savings from closures will take time to recognize as leases are broken, and payrolls are shaved due to attrition. According to an Standard and Poor report, earnings from continuing operations for 2008 are forecasted to be a negative -.61 per share.

COST OF SALES

The cost of sales category includes cost of merchandise sold, as well as receiving and distribution costs. Cost of sales as a percentage of revenues was 50.7 percent for the quarter ended January 31, 2008, compared to 48.5 percent for the same period in the prior year. According to management, this increase of 140 basis points resulted from the decision to liquidate certain discontinued and damaged inventory in lieu of refurbishing and selling the inventory through store channels. A 60 basis point charge was associated with excess inventory and a decline in revenues was recognized, associated with lifetime warranties. Interestingly the effect of gold prices may not materialize in the cost of sales. While Gold is near record high, their inventory is likely to be purchased in advance, and may therefore not materialize into higher prices one year forward, assuming an inflationary environment. However the weak dollar may also effect Zale's purchasing power, as its suppliers most likely originate from overseas, including South Africa for raw materials, and China for its labor in producing jewelry. It should be noted though, according to management's opinion, changes in revenues, net earnings, and inventory valuation that have resulted from inflation and changing prices have not been material during the periods presented (2007). And although currently not material, as stated by management, recent increases in gold prices have negatively effected the cost of merchandise inventory. In a report of risk factors in their annual report, "the trends in inflation rates pertaining to merchandise inventories, especially as they relate to gold and diamond costs, are primary components in determining their last-in, first-out inventory. There is no assurance that inflation will not materially affect us in the future". Management's success in using forward hedging contracts for inventory purchases has yet to be seen, as it will depend on them successfully speculating on the price the gold in the future, no easy task given the volatile commodities market.

Inventory and Fixed Costs.

Average inventory turnover for Zales is acceptable and in line with industry averages, yet other financial ratios indicate industry weakness. Zales has a respectable inventory turnover inline with competitors of 2.5. Compared with the Signet Group of 2.6, Tiffany's of 2.46, it is effective in managing inventory. However there are significant fixed costs which Zales shows weakness in.Calculating revenue per employee however, shows some startling results. Revenue per Employee at Zales of $143,352 which lags behind competitors by a large margin, where Signet is able to enjoy $221,964 per employee and Tiffany's of $290,909 per employee. The heavy concentration of physical stores and mall kiosks also weigh in on margins when compared to online retailers such as Blue Nile, or big box retailers such as Walmart which can utilize retail space to adjust to seasonal demand. Clearance Items: Coupled with their recent $100 million divestiture of inventory, a casual browsing of their website will reveal some 1604 items sold at discount or at clearance prices, the largest of any category. Their aggressive buy one get one 1/2 off inventory reveals and additional 360 items. For comparison's sake, top selling items at Zales reveal 221 items, Wedding items reveal 585 items, Journey jewelry or "love jewelry" reveals 295 items. The abundance of clearance inventory relative to other categories suggests a lack of pricing power and the need to quickly reduced tied up capital in inventory. Competitors such as Tiffany or Blue Nile do not even offer clearance items which may possibly dilute the brand name.

These are some factors which I have so far considered. In closing, I prefer to look for companies which have a wide, sustainable competitive advantage, or as Warren Buffet would prospect for, a "Wide Moat". Discretionary spending of jewelry faces stiff competition, not only from the razor thin margins of Walmart and its jewelry department, but from digital competitors as well, including Internet jeweler Blue Nile, which has the advantages of having tighter inventory control as well as low fixed costs. Only the holiday of season of 2008/2009 will reveal the success of Zales management as they seek to improve upon operations. In the meantime, high valuations of Zales, and implications that it is a growth stock need to be examined carefully.